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The dollar's role as the world's primary reserve currency helps all of us Americans by keeping interest rates low. Foreign countries buy United States Treasury debt not just as an investment, but because dollar-denominated assets are the best way to hold foreign exchange reserves.

This topic is on the minds of American small business owners, I learned last week when speaking to hundreds of store owners at an Ace Hardware conference. I was surprised by how many people button-holed me to chat on the subject.

China may have prompted some interest in the subject: ". . . it is perhaps a good time for the befuddled world to start considering building a de-Americanized world," wrote Liu Chang for China's official news agency Xinhua. With our recent budget crisis, debt ceiling crisis and the 2011 credit rating downgrade, United States finances look shaky. Let's figure out what the reserve currency status means, why it will continue to a large extent, and how the related issues influence the future.

What is a reserve currency? Countries all over the world hold financial reserves, in bonds or money market instruments denominated in some other currency. They also hold gold and Special Drawing Rights issued by the International Monetary Fund. The reserves protect the country's currency against speculative outflows.

Let's say that Ruritania (a fictional country) is suspected of being in poor financial shape. International speculators might sell their own holdings of country's currency, or sell short or sell in forward trades. This will tend to depress the value of the currency. Other speculators may see the attack and join in, further weakening the currency. The country could let its exchange rate fall, but many countries don't like this option. A falling exchange rate makes imports more expensive to its citizens and may also disrupt financing that Ruritanian companies receive from foreign banks.

If Ruritania has sufficient foreign reserves, it could start buying its own currency, selling its foreign currencies to pay for its purchases. With deep reserves, the country could thwart the speculators. In fact, deep reserves would probably prevent the speculation in the first place. The financial speculators know that it is futile to bet against a currency backed by substantial reserves.

The Asian Financial Crisis of 1997-98 taught many countries the value of having large reserves for foreign currencies. Most countries are now pretty heavily invested in their foreign exchange reserves.

The U.S. dollar is the most common currency for international reserves, for good reason. First, because of the size of our economy, there are plenty of dollar-denominated securities available. The market for United States Treasury securities is liquid and deep. "Liquid" means that the securities can be sold quickly. "Deep" means that a substantial amount can be bought or sold without affecting the price too much. These are desirable features of a foreign reserve currency. If Ruritania were to hold an obscure currency, such as the the Pa'anga of the Kingdom of Tonga, it might not find willing buyers on short notice. Even if it did, there is no way that Ruritania could quickly sell billions of Pa'anga without pushing the foreign exchange rate disastrously low. Thus Ruritania needs to own currencies of large countries, which are traded in large amounts on a daily basis.

The dollar fits the need pretty well. The Euro plays second fiddle, with Japanese Yen and British pounds sterling just barely in the band. A number of other currencies are used in small amounts.

An additional requirement for a good reserve currency is that assets denominated in that currency are unlikely to lose value to a great extent. Here's the tricky point. If defaults or credit downgrades were widely expected to reduce the price of U.S. Treasury securities, then other countries would prefer to hold their reserves in some other asset.

The challenge for countries nervous about the U.S. dollar is this: what other currency is a good alternative?

The Euro is a popular reserve currency. Before criticizing the United States fiscal situation, think about Europe. Plenty of countries in the eurozone remain in denial about their overspending and under tax collection. Economic growth prospects are middling at best. However, the Euro is widely used, so financial markets are liquid and deep. I could see the Euro take a little bit more market share of reserve currencies.

The pound sterling is the next most common reserve currency. The size of the British economy justifies the pound's third-place status. If just a single small country needed to support its currency, then pounds would do the trick. If, however, an entire region was in trouble (as with the Asian financial crisis), then the market for sterling-denominated assets would not be deep enough.

The yen is also used in reserves, but Japan's public debt as a percentage of GDP is the highest in the world, edging out Zimbabwe and Greece. One wouldn't opt for the yen over the dollar based on fiscal soundness.

The renminbi is sometimes discussed as a possible reserve currency, due in large part to China's large economy. However, the heavy hand of government foreign exchange controls makes most other countries hesitant to use China's currency.

With this lineup of alternatives, it's no wonder that the dollar continues to be the world's reserve currency. Certainly many countries want some diversification in their reserve portfolio, and for that reason the dollar is only 60 percent of identified currency reserves.

Would further diversification work against the dollar? Not necessarily. Countries have been growing their total reserves at a strong pace. In the past ten years, global reserves have quadrupled. With that growth rate, countries could greatly increase non-dollar reserves without having to sell any greenbacks.

What does the dollar as a world reserve currency mean to us in the United States? First, it triggers substantial demand for our securities. About 30 percent of U.S. debt outstanding is owned by foreign countries in their currency reserves. Without that demand for our treasury bonds, the interest rate that the U.S. Treasury pays would be significantly higher. That would likely mean that even private sector borrowing costs would be higher, as consumer and corporate debt compete with public debt for investors' holdings.

A final note on a related and confusing issue. Several people in the discussions noted that oil is priced in dollars. That fact has no importance at all. Although world petroleum trades use dollars to show the price per barrel, you can buy oil in any currency. Simply call a trader and say that you have Euro, yen, pounds or pesos that you would like to spend on oil. Either the trader will take your currency at an appropriate exchange rate, or you can have your bank do an instant conversion to dollars and then immediately transfer the dollars to the oil seller. You need only own dollars for a second or two, if that.

The dollar will continue to be the most popular world reserve currency. It's share of total reserves may decline, but the absolute number of dollars held by foreign countries will continue to rise. This will help keep our interest rates lower than they otherwise would be. It does not, however, prevent our interest rates from rising in a global market.

Update: After posting this, I read The Relative Unimportance of Seigniorage by David Henderson on the benefits to the United States from so many foreigners holding our currency. This is a different issue than the dollar being the world reserve currency, but it's in the same neighborhood and David does a good job explaining it.

Source: Future Of The Dollar As World Reserve Currency